Exotic Beta Revisited by Mark Carhart, CFA, Ui-Wing Cheah, CFA, Giorgio De Santis, Harry Farrell, and Robert Litterman, CFA Institute.
The authors propose portfolios comprising simple and intuitive risk premiums (exotic betas) that are transparent and cost effective, perform well in different market environments, and are uncorrelated with equities. They are an alternative to traditional portfolios that are defined by their asset class allocations. The authors show that exotic beta investing offers a better risk–return profile than risk parity and hedge fund replication and that adjusting exposures to capture variation in risk premiums further improves performance.
Exotic Beta Revisited – Introduction
The recent financial crisis has imparted many lessons, a critical one being that the investment landscape is continually evolving and that finding appropriate and diversified sources of return is a constant challenge. Traditional equity market beta is a consistent source of return in the very long run, but it has disappointed over the last decade, particularly relative to its risk, which is as great as ever. For all its simplicity and transparency, the equity risk premium consistently exposes investors to sudden and intense drawdowns. Further, some investors expect the equity risk premium to be lower in the future than it has been historically.1
Finding alpha on a consistent basis is especially hard in today’s competitive environment. Hedge funds, proprietary traders, and high-frequency algorithms continuously scour the markets in hopes of finding inefficiencies before others can. Successful alpha strategies also tend to attract additional entrants and lead to crowding that can lower returns and, at times, produce liquidity stresses. This trend has accelerated in recent years as technological and information barriers have receded. For institutional investors who rely heavily on skillbased returns to meet their investment objectives, sourcing consistent alpha has become ever more imperative and difficult.
How should investors respond to these challenges? One way is to focus more carefully on the drivers of risk and return in a portfolio, not simply in terms of stocks versus bonds or alpha versus beta but in terms of developing a better and more complete understanding of the underlying risk factors and other portfolio characteristics, including liquidity, leverage, return per unit of risk, expected correlation in stress scenarios, capacity, and sustainability.
Eight years ago, well before the global financial crisis, we began discussing exotic beta,2 a concept that many investors refer to as “alternative risk premiums,” “risk factor investing,” or “smart beta.”3 We continue to believe this idea is useful to investors, but in this article, we reexamine and update it in the context of the events of the past few years.
Defining and Testing Exotic Beta
We define exotic betas as exposures to risk factors that are uncorrelated with global equity markets and have positive expected returns.4 We describe them as existing on a continuum-a “spectrum”- between alpha and the ubiquitous equity factor. Like alpha, they are a source of uncorrelated returns to most portfolios, but unlike alpha, they are not opportunities created by very short-term inefficiencies or that require a unique skill to exploit. Exotic beta factors are compensated risk factors for which investors earn excess returns. They are transparent, relatively well known, and intuitive. What differentiates exotic beta factors from the equity premium is simply the source of the return.
There is little doubt that the principal risk in global financial markets is equity risk. This risk is pervasive and often embedded in strategies that purport to deliver uncorrelated returns. As we have seen over the past few years, when that dominant risk factor experiences a large negative shock, secondary risk factors can become highly correlated. For example, when liquidity evaporated during the 2007–08 financial crisis, risks that in normal times would be uncorrelated with the market suffered large negative shocks, if only because investors needed to reduce risk and find liquidity. Despite the damage it caused, the crisis demonstrated that this result is not true for all priced risks; for example, pure insurance against hurricanes and earthquakes was not materially affected.
See full article here by CFA Institute.